Utility vs Security Token: What’s Your Cup of Crypto?
In the fast evolving cryptocurrency space, is it better to put your money into a security token or a utility token – and what is the difference between the two?
Security and utility tokens are the two dominant tokens currently in operation in the decentralised crowdsourcing or initial coin offering (ICO) space, although there are major differences between the two that are not widely appreciated.
If a cryptocurrency derives its value from a tradable asset then it is classified as a security token and is subject to regulation by the Securities and Exchange Commission (SEC) in the US, the Financial Conduct Authority (FCA) in the UK, and the European Securities and Markets Authority (ESMA) in the EU.
But if a cryptocurrency derives its value or utility within a closed ecosystem or decentralised network that has no external value in the real world, then it is merely a utility token and thereby escapes the regulatory dragnet in most jurisdictions.
The problem is that the crypto space has experienced such explosive growth in recent years that many start-ups and ICOs are ignorant of this vital distinction – some wilfully – and have either launched security tokens without notifying the appropriate regulatory authorities or are guilty of being security tokens deliberately masquerading as utility tokens in order to evade the regulators’ grasp.
In the US (and pretty much everywhere else), the litmus test as to whether a token is a security or not is the so-called Howey Test, handed down by the US Supreme Court in 1946, which states that a transaction is an investment contract or security if it exhibits all of the following four key features:
1. An investment of money
2. In a common enterprise
3. With an expectation of profits
4. From the efforts of a third party or parties
If a token entails an investment of money but none of the other three elements, then it is not a security, and is not subject to regulation. Utility tokens like Filecoin, tZERO and Ether are indeed utilities – but most of the rest are securities.
Good and bad tokens
As a consequence, some commentators, analysts and coin exchanges have branded all utility tokens as good and all security tokens as bad, which is unfortunate because not all security tokens are bad and not all utility tokens are good.
The SEC has hitherto shown little inclination to acknowledge that there is a distinction between security and utility tokens, with SEC Chairman declaring in February; “I believe every ICO I’ve seen is a security.” This regulatory blind spot has been largely responsible for the US crypto and blockchain sector to relocate offshore – although US attitudes have recently begun to exhibit more flexibility.
But make no mistake, securities that pretend to be utilities or engage in other fraudulent activities that misrepresent to investors what they are in order to sneak under the regulatory radar are being targeted by the US and other regulators.
The SEC has cracked down on fraudulent and non-compliant ICOs such as Tezos, which raised $232 million in 2017, and against AriseBank in January this year – one of the largest ICOs ever – after it raised more than $600 million.
Embrace the regulator
But according to Jamie Bennett, co-founder of Bitassist, a London-based cryptocurrency trader, the strategic choice is not to evade securities regulation but to embrace it and become compliant or be put out of business.
“This space is changing fast, in fact, we are in the midst of a paradigm shift,” Bennett said. “We went from different types of blockchain software towards utility tokens – a currency used within an ecosystem like Steemit – where people pay each other in the Steem currency for work carried out in the closed ecosystem.”
He added: “From there, people began to realise that this was a way to distribute ownership. Tokens introduce liquidity, which enable the transfer of ownership more easily. A security token – tokenising a real world asset – represents a claim to an asset in much the same way as a share.”
Security token lift off
Bennett was adamant that security tokens were going to become the preferred class of token because of their inherent advantages, saying: “A token has to be able to change hands if is to have value, so it is prudent to ensure compliance from the outset. Security tokens that fail to come out of the closet are going to lose value.”
“Coin exchanges aren’t regulated at present, so everyone can be a utility – it doesn’t matter. But there is a growing determination among regulators to crackdown on fraudsters, including securities pretending to be utilities,” he said.
“Two of the biggest US exchanges both applied to the SEC in June for approval to list security tokens,” Bennett added. “The writing is on the wall. Regulation is coming in the US, which is forcing exchanges to change how they operate. The consequence will be that securities pretending to be utilities will be forcibly de-listed, demand for their token will collapse, and the token will be dumped.”
The decision by Coinbase and Circle, the two US giants of crypto currency trading, to seek regulatory approval to list security token is little short of momentous. Assuming that regulatory approval is eventually granted by the SEC, it will radically alter the fund-raising industry, and put ICOs on the same level as IPOs.
Both crypto trading platforms will be able to reach a much wider audience to offer blockchain-based securities than is the case at present – albeit under federal supervision. And similar regulatory concessions are likely to follow elsewhere.
US appoints ‘Crypto Czar’
The crypto landscape continues to evolve. Prior to the Coinbase and Circle Developments, the SEC announced its decision to appointed Valerie Szczepanik – a veteran lawyer with a background in insider trading and the dark web – as its new Crypto Czar.
She will be responsible for applying US security law to the blockchain and crypto currency space that is likely to allow these breakthroughs to develop and flourish without putting the retail investor at risk – the SEC’s core mandate.
“There will always be a role for utility tokens,” Bennett said, “but my money is going to be on security tokens. Compliant security tokens are likely to be the next growth area in the blockchain and crypto space. It’s going to take off.”
Aziza coin security token ICO due October
The Aziza Project, the Ilse of Man-based cryptocurrency that is preparing to launch an ICO later this year in an attempt to fund a ten-well drilling programme on a 22,000 square kilometre concession in Namibia as part of its strategy to provide all Namibians with access to electricity, decided from the outset that it was offering a security token, and that there was no point trying to disguise this inescapable fact.
That prescient early-stage decision has left the Aziza Project’s Aziza coin token well placed to be listed as a security on multiple coin exchanges, where the Aziza coin can be freely traded among buyers and sellers as a fully regulated product.
Robert Pyke, the Aziza Project CEO, said: “One of our very first challenges was existential – we had to decide what we were. We debated endlessly the pros and cons of being a security versus a utility, and even took external advice on the issue – most of whom suggested we structure ourselves as a utility.
In retrospect, our decision to acknowledge that we were a security was the right one as it will now provide our investors with the liquidity needed to trade their Aziza holdings.”